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The rate escape: Quantifying the race between the inevitable rise of interest rates and need for earnings growth

by by Bryan Masters and Evan Lippow

Interest rates remain at historically low levels. The question that everyone is asking is: when will interest rates go up? It is widely believed that at some point within the next couple of years the Federal Reserve will ease off its third round of quantitative easing, and as a result, interest rates will rise closer to the historical average.

The following analysis was done to quantify the possible effect of rising interest rates on commercial real estate values and to answer this question: What growth rate is necessary to sustain property values? We find that commercial property with a 5 percent cap rate will need to observe NOI growth of nearly 7 percent annually to sustain value in the event interest rates rise just 2 percent during the next five years.

One of the most frequently used metrics for valuating real estate investments is the capitalization rate, or cap rate. The simple mathematical formula for deriving a cap rate is the earnings of